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Web posted and Copyright © April 1, 2005, American Bankruptcy Institute.

Hatch: On Assuming or Rejecting Leases under the New Law

The primary focus on S. 256 has been on consumer bankruptcy provisions in general and on the means test in particular. But there are a number of business bankruptcy changes in the 500-page bill. These changes include an entirely new chapter of the code (Ch. 15) dealing with cross-border issues and complex rules governing the netting of certain financial contracts. Section 404 of the bill makes an important change in commercial real property treatment. It amends current §365(d)(4) to provide that the unexpired leases of non-residential real estate in which the debtor is the lessee are deemed rejected and must be immediately surrendered to the lessor by the earlier of 120 days after the commencement of the case, or the date of the confirmation of a plan. The court, for cause, may extend the 120-day period for an additional 90 days, but any subsequent extension is available only with the consent of the lessor.

r. President, the bankruptcy legislation cures some abuses in the Bankruptcy Code regarding executory contracts and unexpired leases.

One provision, §404(a) of the bill, amends §365(d)(4) of the Bankruptcy Code. Presently, §365(d)(4) provides a retail debtor 60 days to decide whether to assume or reject its lease. A bankruptcy judge may extend this deadline for cause—and therein is the problem. Some experts believe that too many bankruptcy judges have allowed this exception essentially to eliminate any notion of a reasonable and firm deadline on a retail debtor's decision to assume or reject a lease. Some bankruptcy judges have been extending this deadline for months and years, often to the date of confirmation of a plan.

This situation can be troublesome. For example, a shopping center operator is a compelled creditor. It has little if any choice but to continue to provide space and services to the debtor in bankruptcy. Yet, the current Code permits a retail debtor as long as years to decide what it will do with its leases. Coupled with the increased use of bankruptcy by retail chains, the Bankruptcy Code is seen by some to be tipped unfairly against the shopping center operator. Some stores curtail their operations or go dark, and still the lessor cannot regain control of its space.

This legislation, like the conference report in the last two Congresses, acts to curb this abuse. It imposes a firm deadline on a retail debtor's decision to assume or reject a lease. It permits a bankruptcy trustee to assume or reject a lease on a date which is the earlier of the date of confirmation of a plan or the date which is 120 days after the date of the order for relief. A further extension of time may be granted, within the 120-day period, for an additional 90 days, for cause, upon motion of the trustee or lessor. Any subsequent extension can only be granted by the judge upon the prior written consent of the lessor, either by the lessor's motion for an extension, or by a motion of the trustee, provided that the trustee has the prior written approval of the lessor. This is important. We are limiting the bankruptcy judges' discretion to grant extensions of the time for the retail debtor to decide whether to assume or reject a lease after a maximum possible period of 210 days from the date of entry of the order of relief. Beyond that maximum period, there is no authority of the judge to grant further time unless the lessor has agreed in writing to the extension.

Retail debtors filing for bankruptcy will undoubtedly factor into their plans this new deadline. Most retail chains undertake a careful review of their financial condition and business outlook before they file for bankruptcy. They will already have an understanding of which leases are ones they wish to assume and which ones they wish to dispose of. The legislation gives them an additional 120 days to decide on what to do with their leases, once they file for bankruptcy. Beyond that 120-day time period, an additional 90 days can be granted for cause. A further extension may be negotiated by the retail debtor and the lessor if circumstances warrant, and any such extension can be granted by a judge only with prior written consent of the lessor. Further, a lessor's prior written approval of one such extension does not constitute approval for any further extensions; each such extension beyond the 210-day period requires the lessor's prior written approval.

The bill in §404(b) also amends §365(f)(1) of the Bankruptcy Code to make sure that all of the provisions of §365(b) of the Code are adhered to and that 365(f) of the Code does not override §365(b).

This addresses another problem under the Bankruptcy Code. The bill helps clarify that an owner should be able to retain control over the mix of retail uses in a shopping center. When an owner enters into a use clause with a retail tenant forbidding assignments of the lease for a use different than that specified in the lease, that clause should be honored. Congress has so intended already, but bankruptcy judges have sometimes ignored the law.

Congress made clear, in §§365(b)(1) and 365(f)(2)(B), that the trustee may assume or assign an executory contract or unexpired lease of the debtor, only if the trustee gives adequate assurance of future performance under the contract or lease.

In §365(b)(3), Congress provided that for purposes of the Bankruptcy Code:

adequate assurance of future performance of a lease of real property in a shopping center includes adequate assurance—
(A) of the source of rent and other consideration due under such lease, and in the case of an assignment, that the financial condition and operating performance of the proposed assignee and its guarantors, if any, shall be similar to the financial condition and operating performance of the debtor and its guarantors, if any, as of the time the debtor became the lessee under the lease;
(B) that any percentage rent due under such lease will not decline substantially;
(C) that assumption or assignment of such lease is subject to all provisions thereof, including (but not limited to) provisions such as a radius, location, use, or exclusivity provision, and will not breach any such provision contained in any other lease, financing agreement or master agreement relating to such shopping center; and
(D) that assumption or assignment of such lease will not disrupt any tenant mix or balance in such shopping center.

Congress added these provisions to the Code in recognition that a shopping center should be allowed to protect its own integrity as an ongoing business enterprise, notwithstanding the bankruptcy of some of its retail tenants. A shopping center operator, for example, must be given broad leeway to determine the mix of retail tenants it leases to. Congress decided that use or similar restrictions in a retail lease, which the retailer cannot evade under non-bankruptcy law, should not be evaded in bankruptcy.

It is my understanding that some bankruptcy judges have not followed this congressional mandate. Under another provision of the Code, §365(f), a number of bankruptcy judges have misconstrued the Code and allowed the assignment of a lease even though terms of the lease are not being followed. This appears to ignore §365(b)(3).

For example, if a shopping center's lease with an educational retailer requires that the premises shall be used solely for the purpose of conducting the retail sale of educational items, as the lease in the In re Simon Property Group. LP v. Learningsmith Inc. (D. Mass. 2000) case provided, then the lessor has a right to insist on adherence to this use clause, even if the retailer files for bankruptcy. The clause is fully enforceable if the retailer is not in a bankruptcy proceeding, and the retailer or the bankruptcy trustee or judge should not be able to evade it in bankruptcy. Otherwise, the shopping center's operator could lose control over the nature of its business.

In the Learningsmith case, the judge allowed the assignment of the lease to a candle retailer because it offered more money than an educational store to buy the lease, in contravention of §365(b)(3) of the Code. As a result, the lessor lost control over the nature of its very business, operating a particular mix of retail stores. If other retailers file for bankruptcy in that shopping center, the same result can occur.

In the past, courts have disagreed about whether §365(f) overrides the provisions of §365(b)(3). For example, in the case of In re Rickles Home Ctrs. Inc., 240 B.R. (D. Del. 1999), appeal dismissed, 209 F.3d 291 (3d Cir.), cert. denied, 531 U.S. 873 (2000), the judge disregarded the use clause and allowed a lease sale to go through to a non-conforming user. However, in In re Trak Auto Corp., 367 F.3d 237 (4th Cir. 2004), an appellate court held that a use clause must be strictly enforced under §365(b)(3) on sale of the lease, notwithstanding §365(f). This legislation provides the necessary clarity by amending §365(f)(1) to help make clear it operates subject to all provisions of §365(b).

I note that §365(d)(4) of the Bankruptcy Code applies to cases under any chapter of Title 11. Language to that effect in the current Code's §365(d)(4) is deleted because it is repetitive of §§103(a) and 901 of the Code, which already make clear that provisions like §365(d)(4) apply to all cases under Title 11.



 

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